What is most entrepreneurs’ dirty little secret?
They don’t understand their financial statement.
And without it, they miss key opportunities and dangers.
It’s OK. We know. You may not know what to do with your financial statements or why you should even care. It’s most entrepreneurs’ dirty little secret – they don’t know what to look for in their financials outside of sales and profits. But what is a Financial Statement and why do I need it anyway?
Do I really need to pay attention to my financial statements? Don’t my sales numbers and bank balances tell the whole story?
In a word, no. A financial statement is your business bible – a written record that conveys the economic health of your company and is far more comprehensive than just the bottom line. It should inform every financial decision that affects the organization.
A typical financial statement consists of three basic components: income statement, balance sheet, and cash flow statement. Each contains unique and important information that is vital to successful growth.
Income Statement: How profitable are we?
Also known as a P&L (profit and loss) statement, this is the most familiar of these three tools to a majority of business owners. It tracks revenue and expenses, and identifies trends within them. It also shows the relative health of your daily business operations, and provides a clear picture of your profitability.
An income statement gives valuable perspective on key questions that face every entrepreneur. Why has our balance increased or decreased? Are we consistent from month to month? Do we need to account for seasonality in our planning?
Some common areas where errors can occur on income statements include calculations of revenue and expenses, cost of goods sold (COGS) classified as overhead, and inconsistencies in how expenses are booked.
Balance Sheet: How healthy are we?
The balance sheet is the black sheep of the financial statement family; misunderstood and left to sit lonely in the corner. But, like your goth sister who read graphic novels and listened to emo music, it’s far more interesting and powerful than you might think.
A balance sheet measures the true health of your business and breaks it down into three categories:
- Assets: What do we own (cash, inventory, equipment)?
- Liabilities: What do we owe in the short and long term (accounts payable, credit cards, lines of credit (LOC)?
- Equity: What’s left after all liabilities are weighed against all assets (owner’s contributions and distributions, retained earnings
A close examination of these categories can illuminate crucial questions. Where are the imbalances between assets and liabilities? Are we liquid? A clean, accurate balance sheet brings these issues into focus. It is a must-have for any business, and the first place a bank (or consulting firm) will look when sizing you up for a loan.
Be cautious of misclassification of assets and liabilities (which can be surprisingly tricky) or improper application of payments to the principal or interest on an LOC. Keep a close eye on debit balances and LOCs, and make sure to capitalize your assets where appropriate.
Cash Flow Statement: Where did all our money go?
After the balance sheet, the next place a bank or investor will look is your cash flow statement. It answers that age-old question that keeps most entrepreneurs up at night – I made all this profit, so why don’t I see it in my bank account?
This document, sadly, suffers from a chronic case of accounting jargon syndrome – the important information contained within is masked by industry-specific language and opaque terminology. You can simplify your approach by focusing in on three key subtotals:
- Cash flow from operations: What did we earn from the day-to-day activities of the business?
- Cash flow from financing: What did we bring in from loans? What did we put in or take out personally?
- Cash flow from investing: What did we spend on equipment or other capital expenses?
Common cash flow woes that this report can illuminate include outdated accounts receivable operations, slow-moving or overstocked inventory, an unhealthy pace of paying off vendors or debt, declining profits, and owners drawing too much money from the business.
A financial statement is a scorecard to measure your business’ health and performance. Taking the time to understand it now will help avoid common mistakes. These often befall individuals who quickly glance at bank account balances or sales figures – and then make vital economic decisions.
Consider Profit Point Consulting as a partner on this journey. Download our free ebook to learn more about the things your CPA probably isn’t telling you … and your bookkeeper doesn’t know.
Profit Point Consulting’s mission is to accelerate the growth of small and medium-sized companies through sound, strategic advice, and proactive financial management. If you need a trusted advisor to help develop and execute your vision, call us at (973) 659-1430 or fill out our contact form.